Leveling the playing field for workers by reforming non-competes

The freedom to work is about as important to the pursuit of happiness as anything one can imagine. The talents and aspirations that people bring to the workplace are as varied as the individuals themselves, making it vital that workers be allowed the maximum possible scope to define their own careers and seek their own fortunes.

Unfortunately, labor market institutions sometimes have a way of making life more difficult for workers. Excessive and poorly-designed occupational licensing is one example, as explained in both an Administration report and a Hamilton Project policy proposal. Another deeply problematic institution is the “non-compete”: a contract between a worker and a firm that restricts the worker’s ability to take new employment. Typically, a worker is prevented from taking a job with a competitor (the definition of which varies across contracts) during a specified period of time after quitting or being fired from her current position. Common sense as well as economic theory tell us that the ability to take new offers of employment, or even to credibly threaten to do so, are an important support for workers’ wages. Cahuc, Postel-Vinay, and Robin (2006) show that this is particularly important for low- and middle-skilled workers.

Yesterday, the White House released a report on non-compete agreements and suggestions for reform. Vice President Biden added his remarks, explaining the issue in powerful moral terms. The White House report followed a Treasury Department analysis of non-competes published in March. The Treasury analysis provides a conceptual framework for thinking about this labor market institution in terms of simple economic theory, within which the growing body of empirical evidence can be evaluated, while the White House report focuses more on best practices for structuring and limiting non-competes.

It will surprise many people to learn just how common non-competes actually are. About 18 percent of all American employees are currently bound by a non-compete, according to Starr, Bishara, and Prescott (2016). Even more surprisingly, non-competes are prevalent among workers with less education and lower incomes: 15 percent of those without a four-year degree and 14 percent of those earning less than $40,000 a year are covered by the contracts. On its face, this is inconsistent with the conventional view of non-competes as unusual agreements only pertaining to executives and high-skilled workers with access to confidential information. So what is going on with non-competes?

The Treasury report helps to clarify thinking about why firms and workers might enter into these arrangements. The first reason is simple: some firms are taking advantage of workers’ lack of awareness of both the non-compete and its job market implications down the road. Recent research suggests that this is an important part of the story; Marx and Fleming (2012) survey electrical engineers and find that “…barely 3 in 10 workers reported that they were told about the non-compete in their job offer. In nearly 70% of cases, the worker was asked to sign the non-compete after accepting the offer – and, consequently, after having turned down (all) other offers. Nearly half the time, the non-compete was not presented to employees until or after the first day at work.” (Marx and Fleming 2012, p. 49)

Along the same lines, Starr, Bishara, and Prescott find that workers frequently are incorrect or confused about the enforceability of their non-competes, and that very few workers actually bargain over the terms of the non-compete. Perhaps most telling is the example of California, where non-competes are essentially unenforceable, but workers still sign the contracts at about the same rate as that prevailing in the rest of the nation. It seems likely that many California firms ask their employees to sign non-competes in hopes that workers do not understand the prospects for legal enforcement.

However, there do exist explanations for non-competes that are more benign, and some have found empirical support in the literature. For instance, firms may be more willing to invest in workers when they believe that workers have limited outside options. Starr (2015) finds that stronger non-compete enforcement is generally associated with more firm-sponsored training, though the mechanism is complicated: state requirements that firms provide “consideration” (e.g., promotions or training) in exchange for a non-compete constitute a weakening of non-compete enforcement but still increase firm-provided training.

Consistent with the traditional view of non-competes, some (but certainly not all) workers with non-competes report possession of trade secrets (Starr, Bishara, and Prescott 2016). Employers may be more willing to share trade secrets with workers who cannot easily leave for a new job, thereby facilitating economic activity that would not have occurred otherwise. But other legal mechanisms exist for such protection, like laws forbidding the theft or disclosure of trade secrets, and in any event many workers with non-competes do not possess such information.

So what should be done? Given our current understanding, states would be justified in taking several measures to rein in the worst abuses of non-competes, including:

States should require that firms provide non-competes to workers when a job offer is extended, and not afterwards. In the case of internal promotion, require that any new non-competes be requested by firms prior to the employee switching to the new position. This gives workers a better opportunity to consider whether they would like to accept the contract.

States should employ enforceability doctrines like “red-pencil,” which give employers an incentive to narrowly tailor their non-competes to be enforceable under state law, lest the entire non-compete be invalidated by an unenforceable provision. Doctrines like “red-pencil” make it harder for employers to rely on the chilling effect of unenforceably-broad contracts.

States should require that employers provide “consideration” in exchange for non-competes. For instance, they could be required to extend a severance payment to workers for as long as they are expected to abide by a non-compete. This would help to restrict the use of non-competes to cases in which they are truly mutually beneficial.

Finally, we need to think seriously about generating new data on non-competes. Both the Treasury and White House reports relied heavily on the research of professors Evan Starr, Norm Bishara, and JJ Prescott. They designed and implemented a survey that provided our first comprehensive information about non-competes and the workers who sign them. As informative as their work has been, we should now take steps to generate more and better data on non-competes, just as has recently been done for occupational licensing. Putting a question or three about non-competes on a supplement to the Current Population Survey, or in panel data like the Survey of Income and Program Participation, would be a great start.